Saturday, November 22, 2008

Google Trends: Rising vs. Falling Gas Prices

According to Google Trends, the phrase "rising gas prices" (red line) has 13.5 times the search volume as "falling gas prices" (blue line) over the last year (see chart above), and even now the search volumes for both phrases are about equal, despite one of the greatest gas price decreases in history over the last few months. Notice also in the bottom of the chart that the News Reference volume was significantly higher during the spring and summer of 2008 when gas prices were rising compared to the recent news volume now that gas prices are plummeting like never before in history!

Like the Dangerfield economy, "falling gas prices" get no respect from the media.

"The trouble with the world is not that people know too little, but that they know so many things that aren't true."--attributed to Mark Twain

However, I think, Paulson is a real doomer (there's an important policy decision regarding Citigroup this weekend):

The $700 billion TARP was originally for exchanging a strong asset (i.e. cash) for a weak asset (e.g. mortgage-backed securities). Then, it was decided exchanging cash (an asset) for stock (a liability) was a better plan. Banks may be more cautious when liabilities increase (since they have to be paid back). Buying "toxic" securities at premiums would seem to make banks more willing to lend.

The Fed was on a path to achieve a soft-landing or a mild recession. However, two major mistakes (see section below) by the Paulson Treasury, i.e. one that worsen the problem and the other that's ineffective changed that path (stock prices, since September 2008, also reflect those mistakes). There's good government policy, bad government policy, and neutral government policy. Imbalances could have been corrected slowly rather than suddenly.

A fourth policy mistake is saving the remaining $410 billion of TARP for the Obama Administration rather than using it now.

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Foreigners sold their goods too cheaply in the U.S. (to maintain acceptable employment levels). This caused the U.S. to overconsume (foreign goods) and underproduce (domestic goods). Foreigners also had to lend those dollars too cheaply (to balance the balance of payments), i.e. through low interest rates, or low rates of return, which spurred U.S. consumption even more. It was a virtuous cycle, for the U.S., of foreigners selling goods too cheaply and then investing that money too cheaply. However, it was unsustainable, because of diminishing marginal utility, i.e. the U.S. cannot overconsume forever without increasingly larger losses by foreigners.

The financial crisis was caused by the economic policies of foreign governments. Foreigners were paid through U.S. consumption. However, foreign investment was mostly in U.S. Treasury bonds. So, fiscal policy was restrictive (the U.S. budget deficit shrunk to $162 billion in 2007, or a little more than 1% of 2007 GDP, while U.S. monetary policy was also restrictive, until late in 2007). The U.S. government had to give that money back. However, U.S. consumers, or households, gained at the expense of U.S. financial firms. So, the U.S. government has to fund U.S. financial firms.

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The first was predictable. However, the second was completely unexpected.

The Bernanke Fed kept a restrictive monetary stance for too long, i.e. the Fed Funds Rate at 5 1/4% until September 2007, and fell behind the curve easing the money supply. This may have resulted in a mild recession.

However, the second major policy mistake turned out to be a disaster. The Paulson Treasury allowed Lehman Brothers to fail, on September 15th, 2008, which coincided with the Ted Spread rocketing and froze the credit market quickly. This single inconsistency in the government's "too big to fail" policy resulted in enormous damage on a global scale. This may result in a moderate or severe recession.

Moreover, the negative news by the liberal media and politicians, which almost completely ignored the benefits of the free market system, including the steeper rise of living standards by U.S. households and the huge efficiency gains of U.S. firms, influenced the masses perceptions and emotions, contributing to a self-fulfilling vicious cycle.

There are so many factors driving this crisis. It is difficult to know where to begin.

Interest rates held too low for too long. Changes to the international banking rules increasing capital requirements for mortgages held by commercial banks which did not apply to mortgage loans held in the form of securities encouraged the securitization of mortgages. Development of securitizcomplex securitized instruments that were difficult to understand let alone rate. Rating models that did not factor in the possibility that house prices would decline. Bipartisan efforts to promote home ownership among low income borrowers with inadequate means and allowing Freddie & Fannie to buy mortgage backed securities without an adequate capital base. Rising home prices allowing borrowers to tap into the capital of their homes through home equity loans. Tax policies that allow borrowers to write off mortgage interest creating an incentive to borrow when rates were low.

Inevitably, interest rates rose from their record low and the party was over. Homeowners found their payments rising and the demand for houses started to taper off. Many had planned to refinance to take advantage of rising home prices but now found prices were falling. Once foreclosures began, the market for mortgage backed securities disappeared overnight and investment firms were looking at billions in losses. Those who had made credit default swaps suddenly found that the unthinkable had happened, the value of the investments they were insuring against impairment was 100% impaired.

What we have witnessed is the perfect storm. Paulson & Bernanke are tasked with an impossible job, trying to bring stability to an excessively leveraged financial system.

To blame them for the can of worms they are trying to clean up like blaming the janitor for the floor being dirty. Paulson & Bernanke have the thankless job of cleaning up after someone else and no matter what they do it will likely not go far enough. It is unlikely that there is anything that they could do that would.

President-elect Obama has managed to look confident and cool in the face of crisis without actually lifting his pinky even dodging the G20 meeting hoping that someone else would handle it. Now, that's leadership we can all believe in (sarcasm warning).

It's important to separate the causes from the effects. Poor U.S. fiscal or economic policy, since September 2008, caused SPX to fall over 500 points in two months (from 1,265 in mid-September to 741 Friday). Before then, the economy was on a path to a mild recession, or at least certainly not a severe recession.

Obama's policies, what I've seen so far, will make Americans work more and harder for fewer and smaller assets and goods. U.S. living standards (i.e. private rather than public assets and goods, and through the consumption side more than the production side) could actually decline for many years.

Anyway, recessions are typically preceded by contractionary monetary and/or fiscal policies, which took place again. It's difficult to achieve a soft-landing, because of lags in the adjustment process.

Qt, however in reply to your statements more directly, Bill Gross of PIMCO in his November 2008 Outlook explains:

"Uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons.

This was how the scientists, the financial wizards with Mensa IQs, visualized the financial system a few years ago: leverageable assets held together by a central bank policy rate at its nucleus with institutional participants playing by the rules of conservative self interest and moderate government regulation. Out of it came exceptionally high returns on assets with minimal risk – the highest returns occurring with the most levered electrons farthest from the nucleus.

Over the past year, however, the process has reversed course...we’ve had a nuclear implosion – destructive fusion not controllable fission...When the process reverses, however, when fusion takes over, an investor wants to be at the center – in Treasury bills or bank CDs."

My comment: It's better when the process reverses slowly rather than quickly.

Also, Bill Gross January 2007 (partial) interview is below:

Bloomberg's Tom Keene: "Bill [Gross], your note every month is always interesting. This last one is one of my favorites. As you know, I'm a big fan of nominal GDP - this, folks, is real GDP plus inflation. It's the 'animal spirits' that's out there. You say be careful, Bill Gross. It looks real good to me, Bill. I see 6% year-over-year nominal. You say that's going to end?"

Pimco's Bill Gross: "I think almost assuredly, because of oil prices. I'm not suggesting it end because of real growth going down - that's the Goldilocks scenario in which we have 2% plus or minus real growth. With oil prices doing what they're doing - if they hold in the $55 range - gosh, we're going to see CPI prints y-o-y over the next three or four months of 0.5% or 1.0% and that means nominal GDP is down in the 3% range. "Ultimately, the inflation component affects the real growth component. To the extend that you have nominal GDP - in my forecast 3 to 3.5%, that's really not enough growth in terms of the economy itself to support asset prices at existing levels. And so, declining assets prices ultimately factor into eventually lower real growth. But that's not for mid-2007 but perhaps for later in the year."

Tom Keene: "When we look at six months of low nominal GDP, is that enough to link directly into the 'animal spirits" of the business investment component of GDP - the "animal spirits" of business men and women?"

Bill Gross: "Well sure it is. When you realize that the average cost of debt in the bond market - and therefore in the economy and this includes mortgages - it is about 5.5%. If you can only grow your wealth and service that debt at 3.5% rate, then that has serious implications. When you go back to 1965, Merrill [Lynch] did this study - in terms of asset prices during periods of time when nominal growth grew less than 4%. Risk assets have been negative in terms of their appreciation and actually bonds have done pretty well. The question becomes why hasn't that happened yet, and I think we're simply in a period of time where there are leads and lags that are much like the leads and lags of Federal Reserve policy."

As much as I'd like to blame the Obama fixation, this has always been pretty standard behavior for the media. Rising gas prices are bad news and therefore newsworthy. Falling gas prices are good news and therefore not news.

Consider the coverage of housing and stock prices over the past couple of years.

Can't really blame the media, though, since when they do try to cover positive news, most people switch channels to see what calamity they're missing.